Spring 2013 Venture Fair and Forum
San Francisco
May 7-9, 2011
Term Sheets and Convertible Notes:
Structuring the Deal
May 8, 2013
Jonathan S. Storper and Leslie A. Keil
jstorper@hansonbridgett.com and lkeil@ hansonbridgett.com
Hanson Bridgett LLP
425 Market Street, 26th Floor
San Francisco, CA 94105
415-777-3200
Convertible Note Basics
• Key Points:
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Term
Conversion: Optional or Automatic
Discount
Prepayment?
Interest Rate
Warrant Coverage
Security
Covenants
Examples
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Total loaned = $1,000,000
Automatic Conversion upon “Qualified Financing”
Qualified Financing = $2,000,000
Loan converts into equity according to the following formula:
(Balance of loan + interest accrued)
Per Share price in Qualified Financing
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Thus, if $2,000,000 raised in a Qualified Financing at $1.00 a share, amount loaned converts
into 1,000,000 shares; if $2,000,000 raised at $0.50 a share, the amount loaned converts into
2,000,000 shares
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Effect of 20% Discount:
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Discount applies to the per share price at which the loan would otherwise convert.
If the $1,000,000 loan would otherwise convert at $1.00 a share, the discounted conversion price
becomes $0.80 a share, yielding 1,250,000 shares on conversion rather than 1,000,000
If the $ $1,000,000 loan would otherwise convert at $0.50 a share, the discounted conversion price
becomes $0.40 a share, yielding 2,500,000 shares on conversion rather than 2,000,000
Term Sheet Basics
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What is a Term Sheet?
Is it Binding?
No Shop
NDAs
Fees
Deal Basics
• Type of Security
• Purchasers – Accredited v. Nonaccredited
• Documents to get the deal done
Dividends
• When paid
• Noncumulative v. Cumulative
Liquidation Preference
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What is it?
How Much?
Participating?
Capped?
Trigger
Examples
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Assume a Series A Preferred round that raises $1,000,000 based on a $2,000,000 premoney valuation $1 + $2 = $3
1/3 = 33%
Thus, upon the closing, the preferred investors will own 33% on a fully diluted basis
Assume a sale for $10,000,000
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Liquidation Preference = 1x non-participating
– Preferred investors get $1,000,000 if they do not convert to common
– Preferred investors get $3,333,333 if they convert to common
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Liquidation Preference = 1x participating
– Preferred investors get $4,000,000 if they do not convert to common
($1,000,000 + $3,000,000)
– Preferred investors get $3,333,333 if they convert to common
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Liquidation Preference = 1x participating capped at 3x
– Preferred investors get $3,000,000 if they do not convert to common
– Preferred investors get $3,333,333 if they convert to common
Conversion
• Optional
• Automatic
• Ratio 1:1
Antidilution
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What is it?
Weighted Average
Narrow- includes preferred and common
Broad- includes preferred, common, options,
warrants, others
• Ratchet
• Carve-outs
Difference Between Broad and Narrow
Weighted Average
• The definition of Stock Outstanding
• Broad: includes Common, Preferred, options,
warrants, etc.
• Narrow: includes only the Preferred
• The more narrow, the larger the adjustment
to the conversion price = greater punitive to
Founders
Example: Ratchet
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Assume:
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Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of
4,000,000 total)
Assume:
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$500,000 raised one year later in Series B at $0.50 a share
Pre-money valuation = $2,000,000
Series B converts to common on a 1:1 basis
Thus, Series B owns 20% of the Company on as-converted basis (i.e., 1,000,000 out of
5,000,000 total)
Assume:
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$1,000,000 raised in Series A at $1.00 per share
Pre-money valuation = $3,000,000
Series A converts to common on a 1:1 basis
No anti-dilution protection, Series A owns 20% of Company after the sale of the Series B (1,000,000
shares out of 5,000,000 total).
Full ratchet anti-dilution protection, then the conversion price for the Series A Preferred is reduced
from $1.00 per share to $0.50 per share.
Thus, full ratchet means that upon conversion, Series A entitled to receive 2,000,000 shares
of common stock rather than 1,000,000 shares of common stock.
Weighted Average Formula
AP = OP x CSO + (NM/OP)
CSO + AS
AP= Adjusted conversion price (after the application of weighted avg antidilution)
OP= Old conversion price (before the application of weighted avg antidilution)
CSO= Number of shares of Common Stock Outstanding immediately prior to
dilutive issuance [the difference between Broad and Narrow]
NM= New Money raised as a result of the dilutive issuance
AS= Number of Additional Shares issued in the dilutive issuance
Example: Broad Based Weighted
Average
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Assume:
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Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of 4,000,000 total)
Assume:
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$500,000 raised one year later in Series B at $0.50 a share
Pre-money valuation = $2,000,000
Series B converts to common on a 1:1 basis
Assume:
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$1,000,000 raised in Series A at $1.00 per share
Pre-money valuation = $3,000,000
Series A converts to common on a 1:1 basis
Broad-based weighted average anti-dilution provision:
$1.00 x 4,000,000 + ($500,000/$1.00) = $0.90
4,000,000 + 1,000,000
Thus, the adjusted conversion price is $0.90 and the conversion ratio is adjusted to 1:0.9
Upon conversion, Series A with broad based weighted average protection would be entitled to receive
1,111,111 shares of common stock (compared to 1,000,000 shares with no anti-dilution protection and
2,000,000 shares with full ratchet protection).
This will have a much less punitive effect on the company's founders and management than a full ratchet antidilution provision
Example: Narrow Based Weighted Average
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Assume:
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Thus, Series A owns 25% of the Company on as-converted basis (i.e., 1,000,000 shares out of 4,000,000
total)
Assume:
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$500,000 raised one year later in Series B at $0.50 a share
Pre-money valuation = $2,000,000
Series B converts to common on a 1:1 basis
Assume:
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$1,000,000 raised in Series A at $1.00 per share
Pre-money valuation = $3,000,000
Series A converts to common on a 1:1 basis
Narrow-based weighted average anti-dilution provision:
$1.00 x 1,000,000 + ($500,000/$1.00) = $0.75
1,000,000 + 1,000,000
Thus, the adjusted conversion price is $0.75 and the conversion ratio is adjusted to 1:0.75
Upon conversion, Series A with narrow based weighted average protection would be entitled to receive
1,333,333 shares of common stock (compared to 1,000,000 shares with no anti-dilution protection,
1,111,111 with broad-based weighted average protection and 2,000,000 shares with full ratchet
protection).
More punitive effect on the company's founders and management than broad based weighted average,
but still less than a full ratchet anti-dilution provision
Redemption
• Mandatory – 5 years (investors may give this up)
• Optional
Board of Directors
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Total number
Number elected by common
Number elected by preferred
Outside directors?
Advise at least 5
Angels elect as group
Protective Provisions
• Voting In General
• What Protective Provisions Cover
– Senior securities
– Liquidation, change of control
– Amendments of Articles, Bylaws
– Change rights of preferred
– Information Rights
– Change in corporate purpose
• How long are they in effect?
Registration Rights
• Demand
• Piggyback
• S-3
Miscellaneous
• Right of First Offer (Right to make first offer)
• Right of First Refusal (Right to make last offer)
• Co-Sale (Right to participate
in the sale)
• Exceptions – certain amount
of shares each year; family
members; estate planning
purposes
• Closing Conditions
Angel Killers
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No Term Sheet
Variance from Term Sheet
Hiding the Ball/Due Diligence Surprises
Cap Table Problems
Management Structure/Team
Material Contracts & Agreements
Board composition
No Clear Exit Strategy
Too Many Cooks
Lack of IP
The End